Investor Demand for Cash Flow Deals

Every day, I talk with institutional investors about deals.  Institutional investors have capital which they need to invest. So, what do I hear from these investors?  What are they looking for?

Today, many tell me they want predictable quarterly cash returns.

Some want fixed payments, something in a debt instrument.

Many, however, will accept some variability in the payments. they’ll take some equity risk, to get a better return.

I’m seeing a large and growing universe of these investors.

If you can offer investors a generally predictable cash return, you can get investment capital.

Naturally, institutional investors will ask what could go wrong to diminish their cash return. The better your answer, the stronger the investor demand and the lower your required payments.

Also, if your investment has underlying assets, like real estate or equipment that can be sold to raise capital in a pinch, this also makes your investment more attractive.

So, if you’re raising capital for an investment that generates strong cash flows, consider using those cash flows to pay investors a periodic cash return. 

I recognize that if you pay out the cash flow to investors which you need to reinvest for growth, you’ll have to raise more capital.

The good news is that if you’ve gained a track record for paying investors their periodic cash return as promised, you’ll have no trouble raising capital at attractive terms.

Please contact me to discuss your capital market goals. Thank you.

Dennis McCarthy

Dennis McCarthy

Court Criticizes Legal “Racket”

A well-regarded Jurist in the Seventh Circuit issued a ruling which was highly critical of a legal practice (called a “racket”) in which in response to a large public corporation’s filing with the SEC for a strategic transaction, one or more plaintiff’s counsel file suit to challenge the adequacy of document disclosure. Rather than fight the suit, many corporations simply settle paying plaintiff’s counsel a handsome fee while making no substantive modification to the SEC documents in question.

For background, when Wallgreens issued a proxy statement to request a vote to reorganize after its combination with Boots, the UK pharmacy chain, Walgreens was sued for a failure of disclosure.

The court noted that such suits are commonplace because, in recent years, 95% of strategic transactions for public companies with market values over $100 million receive such challenges.

In Wallgreen’s case, the Court responded to what appears a simple payoff to plaintiffs’ counsel who received $370,000 for its one month suit. Walgreens put up no resistance. The Jurist stated that the value of the supplemental disclosure added to the proxy “appears to have been nil”.

The Jurist concluded, “[t]he type of class action illustrated by this case — the class action that yields fees for class counsel and nothing for the class — is no better than a racket.”

Corporations and plaintiffs’ counsel are now on notice that the Seventh Circuit will review settlement cases carefully.

For a good explanation of the practice and the ruling in the Walgreen’s case, please read Sheppard Mullin’s article in its Corporate & Securities Law Blog (click here).

Please contact Monarch Bay to discuss your company’s capital market goals.

Regulating Social Media Influencers

The fact that social media influences consumers’ spending decisions should come as no surprise.  Given this power, the Federal government is now applying its rules to the growing phenomenon of online marketing and influencers.

Federal Trade Commission

The Federal Trade Commission, the FTC, is beginning to crack down where social media influencers fail to disclose that their endorsement is paid and often directed, like an advertisement.

For example, the FTC recently settled with Warner Brothers which had used one of the most popular social media personalities, PewDiePie with over 50 million Youtube followers, to promote its new videogame without any indication that Warner Brothers paid for and directed the endorsement.

The FTC wants more clarity for consumers.  A paid endorsement, for example, might include an indication of this fact by including the hashtag #ad early in the copy.

Bloomberg, the online datasource and magazine, carried an interesting story on the FTC’s crackdown which also highlights the growing influence of online content for consumer marketers (click here).

Excerpt

It’s up to the FTC to be more clear and consistent about their policies and enforcement, she said. A lot of influencers think they are following the rules, but in fact are falling short. More than 300,000 sponsored posts on Instagram in July used hashtags like #ad, #sponsored and #sp, up from about 120,000 a year earlier, according to Captiv8. The FTC thinks #ad is okay if it’s at the beginning of a post, but #sp and #spon aren’t.

“If consumers don’t read the words, then there is no effective disclosure,” Ostheimer said. “If you have seven other hashtags at the end of a tweet and it’s mixed up with all these other things, it’s easy for consumers to skip over that. The real test is, did consumers read it and comprehend it?”

Food and Drug Administration

The FTC is not the only Federal agency focusing on online endorsements.  Not long ago, a drug company using Kim Kardashian for a social media promotional post, ran afoul of the FDA, the Food and Drug Administration (click here).

Securities and Exchange Commission

Online promotion of investments, including the new forms of offerings such as crowdfundings and Reg A+ offerings is regulated by the Securities and Exchange Commission, the SEC.

At this time, there appears to be a great deal of experimentation by social media marketers as to what’s effective yet acceptable by regulators.

Monarch Bay is closely following developments in social media marketing especially as applied to the capital markets and the new offering techniques.  For example, Monarch Bay recently posted “Crowdfunding Communication Do’s and Don’ts” (click here).

Please contact Monarch Bay to discuss how these evolving social media marketing techniques might benefit your company’s capital market goals.

Progress on Proxy Access

In a milestone event, ExxonMobil’s shareholders recently approved relatively progressive proxy access board provisions.

Proxy access provisions enable shareholders of a public company to submit director nominees and measures into the corporation’s annual shareholder proxy to be voted on by all shareholders.

The battle to obtain proxy access has been long and contentious (click here for my 2012 post, “Just a Small Leak”).

For an introduction to proxy access, click here for an article by the Council of Institutional Investors.

Excerpt

“Proxy access” is shorthand for a crucial mechanism that gives shareowners a meaningful voice in corporate board elections. It refers to the right of shareowners to place their nominees for director on a company’s proxy card. This lets investors avoid the cost of sending out their own proxy cards when they are dissatisfied with a corporate board and want to run their own candidates for director.

 CII believes that proxy access would invigorate board elections and make boards more responsive to shareowners and more vigilant in their oversight of companies.

What makes the ExxonMobil vote so momentous is the percentage of the vote in favor and the fact that this vote was tinged with climate change controversy, not just good corporate governance (Click here).

Excerpt

The so-called proxy access measure was the first Exxon shareholder proposal since 2006 to be approved, and it was the only one of 11 proposals related to climate change to pass at meetings held Wednesday by Exxon and fellow U.S. oil giant Chevron Corp.

More than 60 percent of Exxon shareholders backed proxy access, which was narrowly defeated last year.

Perhaps this issue has reached a tipping point as ExxonMobil shareholders got a letter recommending acceptance by two of the largest US institutional shareholders, California’s CALPERS and the Comptroller of the City of New York representing NYC’s pension funds (click to read).

We’ll monitor developments on proxy access and report important milestones.

Please contact me to discuss your capital market goals for raising capital and M&A.

New S-1 Registration Provisions

A provision of the recently enacted legislation, known as the FAST Act, makes it easier for smaller public companies to conduct registered offerings.

The reason why this is significant is that smaller public companies face a very unreceptive market when raising capital via private placements, known as PIPE offerings.

Burden to Qualify to Invest in Private Placement

In general, the requirements to qualify as an investor in a private placement leave only a small universe available to consider a private placement offering.

A private placement investor must undergo the paperwork burden to prove the investor qualifies as an accredited investor, with

  • the capability to evaluate the risks of the offering;
  • the willingness to forego immediate liquidity of the securities purchased in the offering; and
  • the ability to sustain the total loss of the investment.

Given the limited universe of investors for private placement offerings, in today’s capital markets, smaller public companies, especially OTC listed companies, typically find only toxic financing available from PIPE investors.  That is, the issuing public company may be able to raise capital but the form of the securities demanded by investors has features which are extremely expensive to the issuer and may, in certain circumstances, result in severe negative impact on the issuer’s stock price, perhaps due to substantial dilution of shares.

In contrast with the limitations of a private placement, an investor in a registered offering:

  • has no paperwork burden to prove eligibility to purchase the securities; and
  • has immediately tradable securities, subject only to the liquidity of the company’s stock.

Given these features of a registered offering, issuers can tap a much broader universe of potential investors for a registered offering which should enable an issuer to obtain better terms than for a private placement.

Why then don’t smaller companies issue shares through registered offerings?

The reasons typically given include:

  • raising capital via a registered offering involves upfront and ongoing costs for legal and accounting work to file an S-1 registration statement without certainty of success in actually raising capital,
  • offering size may be small in relation to the fixed upfront costs noted above; and
  • filing a registered offering is public and would enable a stock short seller to short the issuer’s stock depressing its price then cover the short at a profit with stock purchased on the offering.

The new rules enabled by the FAST Act don’t eliminate all these impediments but eliminate one of the costs and risks, which is the requirement to file additional S-1 supplements once the S-1 is declared effective.

Final rules issued by the SEC on January 13th, implementing the FAST Act, enables companies using the S-1 form of registration statement to incorporate by reference required SEC filings after the S-1 is declared effective.

Up until now, S-1 registration statements could only incorporate by reference prior SEC filings. Larger companies, able to use S-3 registrations could incorporate future SEC filings.

Now a smaller company using an S-1 registration statement, which makes the election to incorporate future SEC filings by reference, need not file an update to its S-1 registration when a new SEC filing is required, such as an 8-K or 10-Q, and risk SEC review and comments.

This is a substantial cost and time saving benefit of this provision of the FAST Act.

Interestingly, this is not the feature which got the attention when the FAST Act was passed or the final rules issued.

Please contact us to discuss your capital market plans.

For background reading on this and other capital market provisions in the FAST Act, please click on the following:

Goodwin Procter article

Excerpt:

The amendment to Form S-1 requires smaller reporting companies that make this election to state in the prospectus contained in the registration statement that all documents subsequently filed by the smaller reporting company pursuant to Sections 13(a), 13(c), 14 or 15(d) of the Exchange Act before the termination of the offering shall be deemed to be incorporated by reference into the prospectus.

This amendment will permit smaller reporting companies to eliminate the additional costs and delays of manual updates to “shelf” registration statements on Form S-1 for resale transactions and continuous offerings that commence promptly after effectiveness and continue for a period in excess of 30 days after effectiveness. This amendment does not change the current requirement that companies must conduct delayed offerings under Rule 415(a)(1)(x) under the Securities Act of 1933 using Form S-3 or Form F-3.

In addition, this amendment does not change the eligibility requirements for companies that wish to incorporate documents filed after the effective date of the registration statement under General Instruction VII to Form S-1. The principal eligibility requirements include the following: (1) the company is required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act, (2) the company has filed all reports and other materials required by Sections 13(a), 14 or 15(d) of the Exchange Act during the preceding 12 months or such shorter period as the company was required to file such reports and materials, (3) the company has filed an annual report required under Section 13(a) or Section 15(d) of the Exchange Act for its most recently completed fiscal year, (4) the company is not a blank check company, a shell company or a registrant for a penny stock offering and (5) the company is not registering an offering that effectuates a business combination transaction).

Corporate Vs Institutional Investors

Corporate investors provide a meaningful portion of the total capital deployed in early to late stage companies today. “In 2015, corporate venture groups participated in 17% of all North American deals, accounting for 24% of the total venture dollars deployed to VC-backed startups” according to data from CB Insights in an article by Rita Waite of Juniper Networks, one of the corporate investors (Click here).

Corporate and institutional investors often differ in motives and styles which Rita Waite summarizes.

In our experience, these differences may be dramatic and may be in conflict as these points illustrate.

Corporate Investors

The Good

Corporate investors may pay a higher value because the candidate may enhance the corporate investor’s business, therefore, return on the investment isn’t solely dependent on the candidate’s performance.

The corporate investor may bring to the investment knowledge, contacts, assets or other advantages while an institutional investor typically brings only capital and less specific synergy.

The Bad

The corporate investor may require some “hook” in the investment agreement to give it a special right to buy the candidate in the future, perhaps at a favorable price or to prevent the sale to a competitor.

The high corporate valuation may dissuade financial investors thereby making the candidate dependent on the corporate investor for capital.

Corporate investors may exert influence to keep the candidate focused on whatever is the business most valuable to the corporate investor, regardless of other opportunities which may present themselves.

The Good

Corporate investors typically want to avoid having the candidate consolidated for financial accounting and, therefore, structure the investment to be a minority interest with essentially no operating influence.

The Bad

Since institutional investors want the opposite, commonly wanting control in both value and major decisions, so teaming corporate with institutional investors can be complicated.

The Perfect Private Equity Deal

The perfect deal, that’s what many private equity firms are searching for.  That’s, a buyout of a company with years of stable to growing free cash flow, moderately high and defensible profit margins and a management team right out of central casting.

The competition for those perfect deals is intense and results in private equity groups paying relatively high prices to win.  My colleague, Randy Schwimmer, author of the online newletter, “The Lead Left” reports the latest statistics in this excerpt from his recent issue:

Excerpt

For one thing, total leverage seems again to be reaching radioactive levels. Thomson Reuters LPC reports total debt to EBITDA for middle market institutional buyouts “skyrocketed” to 6.5x for the third quarter. Admittedly, that’s on a relatively small sampling, but the statistic points to a broader trend.

Higher leverage is being driven by similarly gravity-defying purchase price multiples. Of the four middle market LBOs where information is available, all were over 12x, and three were over 15x. This speaks to the fierce competition for new properties being engaged in by both private equity and strategic corporate buyers.

How long this lasts is anyone’s guess.   But, while it lasts, if your company fits the criteria, you might consider a sale.

To read “The Lead Left”, a subscription newsletter, click here.

SEC Issues Final Reg A Offering Rules

 

The SEC released its long awaited Final Rules designed to make Reg A offerings a practically useful means for private companies to raise capital.

Reg A defines the conditions under which a private company can raise capital in an offering exempt from the SEC’s registration requirements.

Shares purchased pursuant to Reg A, therefore, are freely tradable post-offering, that is, for securities regulation purposes.  Salability of the shares is still practically limited by the liquidity of the market for the shares.

One of the more attractive features of a Reg A offering is that a company can sell to either non-accredited or accredited investors.  This is a major difference from the restrictions imposed on companies using the 506 exemption from SEC registration.

Under the JOBS Act, the SEC was instructed to update the Reg A rules, now known as Reg A+ rules, which had fallen into disuse.

Reg A+ Offerings

Companies that plan to offer securities under the new Reg A+, must submit an offering statement to the SEC for qualification. 1

The Reg A+ offering statement, however, is far simpler than that required for a registered public offering.2  It will require, however, 2 years of financial statement including balance sheets, income, cash flow and equity statements if the company has been in existence that long.

One of the major changes under Reg A+ is the creation of two tiers of offerings, Tier 1 and Tier 2.

Tier 1 of Reg A+ Offerings

Tier 1 permits offering up to $20 million within a 12 month period.

Tier 1 issuers have essentially no ongoing post-offering disclosure requirements other than reporting on securities sold pursuant to the offering.3

Tier 1 offerings, however, still require state securities regulator review of the offering but under a coordinated review process designed to reduce the state “blue sky” review burden.

Tier 2 of Reg A+ Offerings

Tier 2, in contrast, permits offering up to $50 million within a 12 month period but preempts state securities regulation entirely.

Offerings under Tier 2, require the company to make post-offering filings with the SEC including annual and semi-annual financial statements as well as other material current events. 3

A Tier 2 offering also triggers the requirement that the financial statements in both the offering statement and subsequent annual filings be audited.

Each of Tier 1 and Tier 2 offerings have other limitations, including limitations on secondary selling,  which are explained in the SEC’s press release (click here) and Final Rules (click here).

Final Rules Pg. 143

Final Rules Pg. 118

Final Rules Pg. 160

Morrison Foerster, the law firm, has also posted a useful and readable recap (click here).

The NY Venture Hub also posted a readable article (click here).

Gift to Plaintiff’s Bar

businessgiftSecurities fraud litigation attorneys no doubt welcomed a recent ruling by the Second Circuit Court of Appeals (covering New York and other northeastern states).

This decision enables plaintiffs to sue a public company for securities fraud if the company fails to disclose in its SEC filings trends and uncertainties that it could reasonably expect to have a material impact on revenues.

Public companies already disclose a long litany of potential risks, trends and uncertainties.  The disclosure is so voluminous that it practically diminishes its influence.  It’s overkill.

Under this recent ruling, securities fraud litigation attorneys can use “20/20 hindsight” to claim that a company should have disclosed trends and uncertainties that resulted in problems for the company.

Giving the plaintiffs grounds to sue starts the litigation process which often results in a settlement before trial.  Plaintiff’s counsel typically gets a large portion of the settlement payment.  This gives the plaintiff’s bar the incentive to be aggressive in pursuing cases.

The Second Circuit’s ruling conflicts with rulings in other Circuits.  Until this conflict is resolved by the US Supreme Court, the plaintiff’s bar will likely make the most of the opportunity.

For additional background on the ruling, please click here to read an article by Benesch, the law firm, on JDSupra, the online legal resource.

SEC Rethinks Proxy Access Rules

In a surprising action mid-January, the SEC reversed a decision issued in December of last year on what’s known as proxy access rules.

Proxy access rules define who can and how to submit proposals to public companies for inclusion in the company’s proxy statement. They also describe under what circumstances companies can exclude those shareholder proposals which is the specific issue in the SEC decision reversal.

The battle over these rules has been raging for several years as illustrated by my earlier article on this subject (click here).

Corporations and their counsels had declared victory when they defeated an SEC proposal which would have created clear conditions requiring companies to include shareholder proposals in their proxies. This left companies with great discretion over whether to include shareholder proposals.

To further protect companies, many requested “no-action letters” from the SEC indicating that the SEC wouldn’t challenge the company’s decision on its treatment of the specific shareholder proxy submissions.

This was the status quo until last week (January 15) when the SEC withdrew its “no-action letter” issued to Whole Foods and announced that the SEC was re-evaluating its position on proxy access rules and related “no-action letters”.

The SEC has come under increasing criticism for its inaction on the topic since the defeat of its proposal (see article link above). With shareholder activism gaining greater mainstream acceptance, large institutional investors, including the New York City Comptroller’s Office, which oversees funds with $160 billion in assets, have lobbied the SEC to support greater shareholder influence in proxy content.

The decision to reverse the issuance of the Whole Foods “no-action letter” doesn’t indicate how the SEC will decide on the issue of proxy access rules. The SEC has announced, simply, that it is evaluating its position. Companies rightly fear, however, that it may signal that the current environment favorable to companies may change.

The New York Times “Dealbook” has a good article on this topic (click here).

Sheppard Mullin, the law firm, also issued a good article (click here).

A couple public companies have excluded shareholder provisions despite withdrawal of no-action letters by the SEC (click here) for article by Stinson Leonard Street, the law firm.